In October, Wall Street's bull market rally celebrated its two-year anniversary, and it's shown little sign of slowing down. Since 2022 came to a close, the ageless Dow Jones Industrial Average (^DJI 0.95%), widely followed S&P 500 (^GSPC 1.33%), and growth-focused Nasdaq Composite (^IXIC 1.59%) have respectively increased by 31%, 55%, and 82%.
This rally has been fueled by an assortment of factors, including (in no particular order):
- The rise of artificial intelligence (AI).
- The resiliency of the U.S. economy.
- Investor euphoria regarding stock splits in influential businesses.
- Better than expected corporate earnings.
- A substantial uptick in corporate buybacks.
But over the last four months, arguably nothing has been more important to the Dow Jones, S&P 500, and Nasdaq Composite than Donald Trump's November victory and subsequent return to the White House. During Trump's first term in office, the Dow, S&P 500, and Nasdaq catapulted higher by 57%, 70%, and 142%, respectively. To say that investors are looking for an encore would be an understatement.
President Trump delivering remarks. Image source: Official White House Photo by Joyce N. Boghosian, courtesy of the National Archives.
The optimism that accompanies Trump's second term has to do with the belief that he'll seek to lower the peak marginal corporate income tax rate and foster deregulation. The former is likely to inspire record share repurchases from S&P 500 companies, while the later should encourage dealmaking and bring new innovations to market at a faster pace.
While the table would appear to be set for additional upside for Wall Street, one historically flawless indicator, which sports more than 150 years of back-tested data, suggests the party may be nearing its end.
History suggests President Trump can oversee a sizable stock market decline
Though the expected implementation of tariffs and what they might do to the prevailing rate of inflation has been an early concern of Trump's second term, there's a far bigger fish in the pond -- and it has nothing to do with Trump's various proposals.
The indicator that foretells of trouble to come for Wall Street is none other than the S&P 500's Shiller price-to-earnings (P/E) Ratio, which is also known as the cyclically adjusted P/E Ratio (CAPE Ratio).
To get the obvious out of the way, "value" is a bit of a subjective term. Since everyone's investment goals and risk tolerance varies, what one investor deems to be expensive might be considered a bargain by another.
Most investors tend to rely on the time-tested P/E ratio as a quick and easy way to decipher if a stock (or the broader market) is relatively cheap or pricey. The P/E ratio, which divides a company's share price by its trailing-12-month earnings per share (EPS), works great for mature businesses, but high-growth companies and recessions/shock events can significantly reduce the reliability of this valuation measure.
Meanwhile, the Shiller P/E Ratio is based on average inflation-adjusted EPS over the last 10 years. By including 10 years' worth of EPS history, it ensures that shock events can't skew it.
S&P 500 Shiller CAPE Ratio data by YCharts.
Although the S&P 500's Shiller P/E didn't gain prominence until the late 1990s, it's been back-tested to January 1871. Over this 154-year period, the average multiple is 17.21. As of the closing bell on Feb. 26, the S&P 500's Shiller P/E clocked in at a multiple of 37.55.
To put the rarity of this reading into perspective, there have only been six instances since 1871, including the present, where the Shiller P/E has surpassed 30 for at least two months. Following each of the previous five instances, the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite, eventually, declined by 20% to 89%.
It's worth noting that the Shiller P/E is in no way a timing tool. Whereas crossing above a multiple of 30 resulted in significant downside in a matter of months during the Great Depression, valuations remained extended for more than four years leading up to the dot-com bubble. While there's no rhyme or reason to when stock market corrections begin, the Shiller P/E has a flawless track record of foreshadowing these eventual moves lower.
In modern times -- i.e., since the internet went mainstream and online trading proliferated three decades ago -- the Shiller P/E's trough during stock market downturns has often been in the neighborhood of 22. A decline from the peak reading of 38.89 during the current bull market to roughly 22 would represent a 43% drop. More importantly, it would result in the benchmark S&P 500 "crashing" by approximately 40% from its all-time high.
Through no fault of his own -- we'd be having this same discussion if Kamala Harris was victorious in November -- President Donald Trump may oversee a valuation-driven 40% plunge in stocks.
Image source: Getty Images.
Thankfully, stock market cycles aren't linear
While the prospect of a bear market decline or stock market crash may not sit well with investors, perspective can change everything on Wall Street.
Truth be told, stock market corrections, bear markets, and even crashes are a normal, healthy, and inevitable part of the investing cycle. No amount of fiscal or monetary policy changes, or well-wishing from the investment community, can stop downturns from cropping up from time to time.
What investors can take solace in is knowing that stock market boom-and-bust cycles aren't linear.
Back in June 2023, the analysts at Bespoke Investment Group posted a data set on social media platform X that compared the length of every bull and bear market dating to the start of the Great Depression in September 1929. This roughly 94-year history demonstrated the stark contrast between stock market downturns and periods of expansion.
It's official. A new bull market is confirmed.
-- Bespoke (@bespokeinvest) June 8, 2023
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
On one side of the coin, the average S&P 500 bear market lasted 286 calendar days, which equates to roughly 9.5 months. On the other hand, the typical bull market for the benchmark index stuck around for 1,011 calendar days, which is roughly two years and nine months (around 3.5 times longer than the average bear market).
Furthermore, no bear market in 94 years endured longer than 630 calendar days. In comparison, 14 out of 27 S&P 500 bull markets, including the current bull market (when extrapolated to present day), were in place longer than 630 calendar days.
The ability for investors to take a step back and examine the big picture will show that, while downturns are normal and inevitable, patience is rewarded. According to a back-tested analysis by Crestmont Research, every rolling 20-year period for the S&P 500 since 1900 would have produced a positive total return, including dividends.
Regardless of whether President Trump's second term features another extended bull market run-up or a bear market, history is quite clear that the Dow Jones, S&P 500, and Nasdaq Composite should be markedly higher 20 years from now.
